Morning Report: The Fed worries about the yield curve

Vital Statistics:

			Last	Change
S&P futures			2903	3
Eurostoxx index			386.36	.8
Oil (WTI)			68.91	0.02
10 Year Government Bond Yield				2.87%

30 Year Fixed rate mortgage                              4.58%

Stocks are higher this morning on optimism over trade talks with Mexico. Bonds and MBS are down. 

We saw a strong buildup of inventory in July, both at the retail level and the wholesale level. Inventory growth was negative in the second quarter, which depressed GDP growth slightly. This improvement in inventories will provide a boost to the third quarter numbers. Durable goods and autos led the increase, with retail inventories up 0.4% and wholesale inventories up 0.7%. 

Redbook reported that same store sales rose 5.1% last week, which was the third fastest pace this year. This bodes well for the back-to-school numbers which are the best predictors of the holiday shopping season. Consumption has been generally strong and these numbers bear that out.

Consumer confidence jumped to 133.4 in August according to the Conference Board. This is the highest level since late 2000. 

House prices rose 6.2% in June, according to the Case-Shiller home price index.  Las Vegas, San Francisco, and Seattle reported double-digit increases. The laggards included New York, Chicago and Washington DC which reported low single-digit gains. Las Vegas is one of the fastest growing US cities in terms of population and employment growth, which explains the rise there. Seattle and San Francisco has restricted supply along with foreign demand. On the other side, the Northeast continues to stagnate. 

The Urban Institute looked at mortgage denial rates along demographic lines and found that most of the studies that report discrimination overstate denial rates because they fail to take into account incomes and credit scores. While they still found some evidence of racial disparity it is much lower when you correct for these things. Not sure if the difference is statistically significant though. Given that CRA loans are worth more than traditional loans (all things being equal) it is surprising that there is any difference at all. 

As the long end of the curve continues to rally, we will have a steady diet of recession prediction stories in the business press. The latest Reuters story cites a Federal Reserve study that suggests the market may be warning of a potential recession: “In light of the evidence on its predictive power for recessions, the recent evolution of the yield curve suggests that recession risk might be rising,” wrote San Francisco Fed research advisers Michael Bauer and Thomas Mertens. 

The flattening yield curve provides plenty of fodder for the Wall of Worry, however there are a couple of things to bear in mind. First, the yield curve almost always flattens during a tightening cycle. Take a look at the chart below, and you can see the yield curve flatten as short term rates rise. 

The behavior of the yield curve is 100% normal. Not only that, longer term interest rates are being held artificially low due to the behavior of central bankers throughout the world. The Fed is still buying Treasuries, albeit at a slower pace, while Japanese and European central bankers are pushing down long-term rates, which influences US rates. The signal-to-noise ratio of the yield curve is extremely low right now. Finally, the short Treasury trade is probably the biggest macro bet on the Street right now. Every wiseguy is short, and that means you will sometimes get these rallies for no apparent reason. 

Morning Report: Fed is looking for new recessionary indicators

Vital Statistics:

			Last	Change
S&P futures			2790	16
Eurostoxx index			384.01	2.61
Oil (WTI)			70.92	0.54
10 Year Government Bond Yield				2.86%
30 Year fixed rate mortgage				4.53%

Stocks are higher after China made some conciliatory comments regarding the trade situation. Bonds and MBS are flat. 

Inflation at the consumer level remains under control, with the consumer price index rising 0.2% MOM / 2.9% YOY. Ex-food and energy it rose 0.2% / 2.3%. These numbers were more or less in line with Street expectations. Energy, especially petroleum drove the increase in the index. Housing also pushed up the index, while autos and utilities exerted downward pressure. 

Initial Jobless Claims fell to 214,000 last week, which is at levels we haven't seen since the early 1970s (when we had a draft). 

Loan performance continues to improve, according to CoreLogic. The 30+ DQ rate fell from 4.8% to 4.2% in April. DQ rates are near historic lows, except for FL, TX, and LA which are still dealing with the fallout from Hurricane Harvey. The national foreclosure rate fell by 10 basis points to 0.6%. Home price appreciation of 7% is helping matters. In fact, home equity is increasing rapidly, but HELOC are not. 

As the 2s-10s spread decreases, many in the financial press are worrying whether the slope of the yield curve is signalling a recession. We already have some strategists calling for the yield curve to invert sometime in 2019. An inverted yield curve (where short term rates are higher than long term rates) has historically been a strong recessionary signal. As a general rule, the yield curve flattens during tightening cycles. In fact, it did invert in the late 90s (before the stock market bubble burst) and during the real estate bubble (before the Great Recession). 

Recent Fed research indicates the 2s-10s spread may not be the best signal of an upcoming recession. It suggests the spread between the 3 month T bills and 18 month Treasuries could be more predictive. Another signal is the Eurodollar futures market. The idea is that the Fed would use these indicators as a yellow signal and stop tightening before they risk a recession. 

To me at least, the last two recessions had very little to do with the Fed. We had a stock market bubble, and we had a residential real estate bubble. To say the Fed caused those recessions implies that these bubbles would have kept on going had the Fed just stayed away (or stopped tightening sooner). That is a big assumption - all bubbles eventually come to an end, and when they do you have a recession. The tightening may have been the catalyst to initiate the recession, that is a question of "when," not "if." We were going to have a recession given we had a bubble in place already. And the Fed might have been guilty of causing the bubble in the first place, but that is a separate question. 

Of course, all bets are off when it comes to this yield curve versus the past. The size of the Fed's balance sheet relative to the economy is vastly different this time around. Pre-Great Recession, the Fed had about $800 billion worth of assets. Now it is about $4.4 trillion. To draw comparisons, you would have to estimate where the 10 year would have been without Operation Twist, QE1, QE2, and QE3. Punch line, the yield curve may in fact invert if the Fed continues to tighten and inflation remains under control. The signal-to-noise ratio of the yield curve is extremely low, so take it with a grain of salt. 

Morning Report: New Home Sales jump

Vital Statistics:

			Last	Change
S&P futures			2745	-14.5
Eurostoxx index			379.79	-5.22
Oil (WTI)			69.07	0.49
10 Year Government Bond Yield				2.89%
30 Year fixed rate mortgage				4.57%

Stocks are lower this morning on continued trade tensions. Bonds and MBS are up

Economic activity decelerated in May, according to the Chicago Fed National Activity Index. Production-related indicators were a drag on the index (probably an effect of trade issues) while employment-related indicators had a positive impact once again. This index is a meta-index of 85 different sub-indices, and while it is backward-looking and generally not market moving, it provides a good global snapshot of the economy. 

The trade war is beginning to have some real economic effects as the CFNAI indicated. While it is primarily limited to steel, many companies that use it as an input are raising prices, which is going to have a few negative effects on the economy - first firms that use steel and cannot pass on price increases are probably going to lay off workers, while the inflationary pressures from increased prices will keep the Fed raising interest rates. Retaliatory tariffs from our partners are causing US exporters to shift production overseas. Note that lumber tariffs are increasing the price of home construction, which is another drag on the economy. 

Given the recessionary potential of trade wars the shape of the yield curve is going to become a bigger talking point for the business press and will be watched closely by the Fed. The shape of the yield curve essentially means the difference between short term rates and long term rates. The most common description is the 2s-10s spread, which is about 34 basis points at the moment. When the yield curve is strongly upward sloping (in other words, the 10 year yield is a lot higher than the 2 year yield) it generally means one of two things: either (a) the market is worried about inflation, and is therefore requiring a high interest rate to entice people to invest in Treasuries long term, or (b) the economy is so strong that investors prefer to put their money in more risky assets and therefore Treasuries have to offer a higher rate to get people interested. For the most part, the US yield curve has been in the second camp. 

As the Fed has been raising the Fed Funds rate, the yield on shorter-term paper (like the 2 year) has been going up faster than the rate on the 10 year. Historically, the yield curve has flattened during tightening cycles, so this is nothing to be alarmed about. If the yield curve inverts, then that has historically been associated with the Fed overdoing it and it is taken as a recessionary signal. In the current environment, the flattening of the yield curve looks more like typical curve behavior during a tightening cycle, and not a signal of a recession. Don't forget the yield curve has been highly influenced by central bank behavior. The Fed could drive up long-term rates by hinting at the possibility of selling some of its portfolio. Bottom line, the business press will be talking about the curve more and more, especially if the trade war begins to snowball and we start seeing a combination of rising input costs with a slowing out output. 

New Home sales increased 6.7% MOM and 14.1% YOY to a seasonally adjusted annual rate of 689,000. This is the highest print since November last year. Interestingly, sales rose in the South, but fell everywhere else. In the West, where the supply shortage is most acute, sales fell by 9% MOM and are flat YOY. Both the median and average sales price fell, which is surprising given the torrid pace of home price appreciation in the home price indices like Case-Shiller and the jump in existing home sales prices according to NAR. It appears that more sales at the lower price points was behind the drop. Luxury sales have been more or less flat for the past year. Eventually tax reform is going to have an effect on the top end of the market, as luxury real estate is simply more expensive due to the changes in mortgage interest and the fact that most of the $1MM+ inventory is in high tax states. We will get more of a read on new homes this week as Lennar and KB both report earnings. 

Fears of rising interest rates have clearly had no negative effects on new home sales. Given the acute housing shortage and the fact that rates are still very low historically, this isn't really a surprise

The Trump Administration announced a plan to reorganize many governmental agencies. The biggest one would merge the Department of Labor and the Department of Education into one agency. On the housing side, USDA loans would be moved from USDA to HUD, which is where they probably belonged in the first place. VA loans will remain under the VA however. Community Development Block Grants would move to Commerce from HUD. The document discusses the need to reform the GSEs and lays out broad ideas, but nothing concrete. 

Morning Report: James Bullard thinks no more hikes are warranted

Vital Statistics:

			Last	Change
S&P futures			2722	3.75
Eurostoxx index			392.17	0.2
Oil (WTI)			71.3	-0.06
10 Year Government Bond Yield				2.96%
30 Year fixed rate mortgage				4.56%

Stocks are higher this morning on no real news. Bonds and MBS are flat. 

Import prices rose 0.3% MOM and 3.3% YOY, driven by oil. Ex-energy import prices were flat. 

St. Louis Federal Reserve Head James Bullard said that interest rates may already be at the level where they are no longer stimulating the economy. There are “reasons for caution in raising the policy rate further given current macroeconomic conditions” he said in his prepared remarks. Bullard has generally been considered a dove, so this is not much of a surprise. He is also a non-voter. He believes that there is little in the inflationary pressures being signaled in the market. 

With respect to inflation signalling, he has a point. The spread between the 30 year bond and the 5 year bond is now the narrowest since 2007. Note that the yield curve generally flattens during tightening phases and is probably not signifying the type of deflationary period that 2007 did. Given all of the QE over the past decade, the signals from the bond markets are heavily distorted and should be taken with a grain of salt. Note short Treasuries is one of the biggest hedge fund trades on the Street. 

Are the homebuilders set to outperform going forward? They have suffered more than the market during the recent declines, but the environment should be favorable for the sector going forward. With a shortage of housing, high demand and rising prices, the sector should be in good shape. The problem for investors? The sector is highly cyclical, and the stock behavior reflects that. In other words, earnings will rise and fall, and the multiple will expand and contract, dampening the effect. So, if the average multiple is typically mid-teens, don't be surprised if P/E ratios fall to the high single digits during boom times. 

Q2 GDP is currently tracking at 3.7%. 

Sen Pat Toomey says that the Trump Administration doesn't have the authority to pull out of NAFTA, since it was passed by Congress. On the other hand, the Admin does have the authority to pull out of the Iran Deal, as well as the Paris Accords because they were only deals with the Obama Administration and not the US - never ratified by Congress. 

Morning Report: Don't fret the flattening yield curve

Vital Statistics:

			Last	Change
S&P futures			2701.75	-8
Eurostoxx index			381.94	0.11
Oil (WTI)			69.26	0.79
10 Year Government Bond Yield				2.90%
30 Year fixed rate mortgage				4.44%

Stocks are lower as commodities surge. Bonds and MBS are down.

The US imposed sanctions on Russia's Rusal, which has sent aluminum prices up 30% and nickel to 3 year highs. This has the potential to spill through to finished products and bump up inflation. As a general rule, commodity push inflation generally isn't persistent. An old saw in the commodity markets: the cure for high prices is... high prices. 

Initial Jobless Claims ticked up to 232,000 last week, still well below historical numbers. 

Investors are starting to worry about the inverted yield curve. An inverted yield curve (where short term rates are higher than long term rates) has historically signaled a recession. The spread between the 10 year and the 2 year is around 41 basis points, which is a 10 year low. Is that what the yield curve is telling us now? I would answer this way: the yield curve is so manipulated by central banks at the moment, that the information it is putting out should be taken with a boulder of salt. We are in uncharted territory, where long term rates are no longer set purely by market forces. 

Also, take a look at the chart below, where I plotted the last 4 tightening cycles. In the last 2 cycles, the yield curve inverted, by a lot. In late 2000, the yield curve inverted by 100 basis points - that would be like the Fed taking the FF rate up to 4% while the 10 year hovers around here - at 3%. I would note that the mid 90s tightening cycle didn't cause a recession, and the late 90s and mid 00s tightening cycles didn't result in recessions immediately - it took years before the economy entered into a recession. 

The question is whether the Fed caused these recessions. It is possible, and the Fed was probably the catalyst to burst the late 90s stock market bubble and the mid 00s real estate bubbles. But these were going to burst anyway. It doesn't really matter what the catalyst is. This time around, we don't really have a similar bubble - we may have pockets of overvaluation, but we don't have bubbles that the typical American is invested heavily in. Not like stock or houses. I think the Fed is happy to gradually get off the zero bound and once we are at 3% on the Fed funds rate will be content to stop. I could see the 10 year going absolutely nowhere during that time. 

My take is this: take the shape of the yield curve as a very weak and distorted economic signal - the labor data will tell you what is really going on, and the labor data is signalling expansion, not recession. 

Don't forget that bond rates are set in a global market, and relative value trading between sovereign bonds will play a role. The US 2 year is at a multi-decade premium to the German 2 year, and in theory, that should mean that investors sell Bunds to buy Treasuries. The reason why that isn't happening? The US dollar, which isn't buying the Administration's rhetoric. 

Facebook wants to get into the semiconductor business. Really. First Zillow wants to get into the house flipping business and now this. I don't understand why companies with great business models want to dilute them. Both companies have a competitive moat with a largely recession-proof business model. The semiconductor business is one of the most cutthroat, lousy businesses this side of refineries and airlines. Take a look at QCOM today. 

The NAHB remodeling index dipped in March, driven by bad weather in the Northeast and the Midwest. With home affordability slipping due to higher interest rates and home prices, remodeling remains a good substitute for moving up. 

Morning Report: What does the flattening yield curve mean?

Vital Statistics:

	Last	Change
S&P Futures	2572.5	-7.0
Eurostoxx Index	384.9	-3.8
Oil (WTI)	56.9	0.1
US dollar index	87.7	0.0
10 Year Govt Bond Yield	2.38%
Current Coupon Fannie Mae TBA	102.875
Current Coupon Ginnie Mae TBA	103.938
30 Year Fixed Rate Mortgage	3.95

Stocks are lower this morning after General Electric cut its dividend in half. Bonds and MBS are up.

We will have a lot of data this week, along with a plenty of Fed-Speak. None of the data should be all that market-moving, but watch the inflation numbers on Tuesday and Wednesday. We will also get housing starts and industrial production. 

Many market participants are watching the slope of the yield curve and warning that it could be indicating a recession ahead. The slope of the yield curve is most often measured by the difference between the 10 year bond and the 2 year bond (the 2s-10s spread). The 10 year rate is usually higher than the 2 year rate, but that relationship can move around a lot, especially when the Fed is active. Most are using comparisons from the beginning of the year, which is somewhat exaggerated by the initial post-election jump in rates. The Trump Reflation Trade turned out to be relatively short-lived, and it exaggerated the slope of the yield curve. That said, we have typically seen a curve flattening during tightening regimes. Some participants are predicting the curve could invert next year, if the Fed can't get inflation to rise. But supposedly the fast money is playing the yield curve flattening trade and this is one of the biggest trades on the Street. 

One effect of a flattening yield curve will be to make the early payment pickup in ARMS less dramatic than it otherwise would be. ARMS are based off of LIBOR, while the 30 year rate is based more on the 10-year. If LIBOR is rising relative to the 10 year (which you would expect to see in a flattening yield curve environment) then borrowers would be better off refinancing out of an ARM and into a 30 year fixed. In a tough environment, this can be a way to get some loans in the door, along with the FHA to conventional without MI refi. 

Tax reform will influence the shape of the curve as well. If tax reform doesn't get done this year, it probably is doomed for the immediate future, as midterm elections will dominate 2018. One strategist sees a 15% correction in the stock market if tax reform doesn't get done. Expectations for a corporate tax cut boosted the S&P 500 by 20% this year. Note that earnings have been increasing for the S&P 500 as well, so that provides support for valuations. Look at the chart below: The blue line is the absolute level of the S&P 500, while the orange line is earnings per share. Granted, the stock market theoretically looks at forward earnings and not contemporaneous or past earnings, but as long as earnings keep rising, the stock market